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Warren Buffett and Charlie Munger: Building a Circle of Competence

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Every value investor knows about Warren Buffett (Trades, Portfolio)'s "circle of competence" - the idea that investors should define the parameters of their knowledge and stick to them. Doing so allows one to focus on what they are actually good at, and helps to douse the temptation to chase after glamour stocks they may not understand. But how does one actually know what to focus on? At the 2019 Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B) annual shareholder meeting, Buffett and his partner, Charlie Munger (Trades, Portfolio), talked about how they developed their own circles of competence.

Find your edge

The Berkshire duo were asked, if they were starting out today, whether they would still aim to build a wide, general framework for investment, or whether they would choose to be more specialized. Buffett said that when he was starting out more than six decades ago, he quickly realized he understood the insurance industry very well. It intuitively made sense to him. Conversely, he did not understand the retail industry, despite working there in his early life. So his advice to aspiring investors was to figure out what makes sense early on, and then focus on that.

You may find you have a good grasp on the fundamentals of energy companies, that the valuation metrics applied to oil and gas producers make sense to you. Prior experience can be of help here. Peter Lynch would advise that retail investors need to use the edge they already have. So if you are a car mechanic, you may have an edge in the automotive industry that an analyst at an investment bank (who may not even own a car) does not.

Similarly, if you are a doctor or biochemist, you may understand the pharmaceutical industry and may be able to gauge the likelihood of a particular drug gaining Food and Drug Administration approval before the professionals do. It all comes down to nailing down your strengths, focusing on developing them and not worrying about your weaknesses.

Specialize or generalize?

However, Buffett and Munger themselves certainly have more than one club in their proverbial golf bags. With characteristic humour, Munger said:

"The great strategy for the mass of humanity is to specialize. Nobody wants to go to a doctor that's half proctologist and half dentist. So the ordinary way to succeed is to narrowly specialize, Warren and I didn't do that."

The reason why they chose to be generalists is quite interesting. Back in the early days of their careers, there were far more opportunities to be had in special situations - discovering undervalued companies on a case-by-case basis, rather than focusing on a particular sector or industry.

Buffett described a situation where he walked into the office of a potential investment target to ask management some questions. To his surprise, he was told he was the first person to ever come calling! He went on to say that it used to be easier to be a generalist because there was less competition among security analysts and investors. Nowadays, analysts are highly specialized. So perhaps the moral of this story is that you should find one specific thing you are extremely knowledgeable about and stick to it. You can't go wrong by focusing on what you're good at.

Disclosure: The author owns no stocks mentioned.

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This article first appeared on GuruFocus.